Krish Trivedi & Arnee Mujoo
In India, the early-stage entrepreneurs are now presented with a choice between two financing tools which are the convertible notes and the Indian Simple Agreement for Future Equity (“iSAFE”). While the concept of convertible notes have been well defined in the Indian legislations, a Simple Agreement for Future Equity (“SAFE”) is a practice borrowed specifically from the United States and is yet to be formalized in the Indian law. It is a contract through which an investor provides funding now in exchange for the right to receive equity in a future priced round.
In both cases, the decision relating to valuations is delayed until the next priced round. They are presented as an easier and quicker route compared to doing a priced round right at the beginning of the startup. But the two rest on entirely different legal foundations in India and have different effects on term sheets.
Convertible notes are legally recognized
The convertible note in India cannot be defined as a mere ‘IOU’. A 2017 notification to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 defined the concept of ‘convertible note’ as any financial instrument issued by the startup that initially a debt and is either payable or can be converted to equity within a specified period of time according to the terms mentioned in the instrument itself. This definition also exists under Rule 2(e) of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“FEMA Rules”) and under Rule 2(1)(c)(xvii) of the Companies (Acceptance of Deposits) Rules, 2014.
The eligibility criteria is strict, only a privately-held enterprise officially classified as a ‘startup’ by the Department for Promotion of Industry and Internal Trade (“DPIIT”) may issue it and minimum amount that must be invested by an individual investor in one installment shall be 25,00,000 INR (Twenty Five Lakhs Indian Rupees). For almost half a decade, FEMA Rules limited the period for conversion or redemption to 5 (five) years, while the Companies Act 2013 (“CA 2013”) permitted a period of up to 10 (ten) years, creating a direct inconsistency between the two regulatory frameworks and exposing startups raising capital from both resident and non-resident investors through the same instrument to the risk of regulatory non-compliance. The 2022 amendment to FEMA Rules brought parity between the two periods, limiting them to ten years.
This ensured legal clarity for the investors. The convertible notes are debt instruments until conversion, meaning that a holder of such notes is a creditor who enjoys all the rights of a creditor, among which is, upon maturity of the debt and in the case of its default, the ability to initiate proceedings against the borrower, even going through the process of liquidation of the business. What is dangerous for the issuing startup is precisely this quality of the convertible note, that means, if the startup fails to complete an authorized round within 10 (ten) years, it will be obligated to pay real money it probably does not have.
India’s version of SAFE
SAFE was introduced by Y Combinator in the late 2013 and has since been used by numerous startups and venture capital firms in the United States. It is not a debt instrument, there is no maturity date nor any interest to pay. This creates under the Indian law, while the CA 2013 defines shares, preference shares and debentures, there is no place for SAFEs in the legislation. An agreement like SAFE which provides equity in exchange for money without an instrument is left in an uncertain state of the law, which until now has not been challenged through litigation in India.
This led to the invention of iSAFE, the Indian version of SAFE, which is a similarly structured but under the umbrella of Compulsorily Convertible Preference Shares (“CCPS“) under Sections 42, 55 and 62 of the CA 2013 read along with the Companies (Share Capital and Debentures) Rules, 2014 and the Companies (Prospectus and Allotment of Securities) Rules, 2014. Being regulated instruments under Section 62 of the CA 2013 allows CCPS to be more flexible in terms of their characteristics compared to other types of shares. Essentially, it requires that the company increases its authorized share capital before raising funds. CCPS typically come with a nominal dividend of around 0.0001%, which is just enough to satisfy the requirement of the preference-share, after which the instrument will either convert to equity when a subsequent funding round happens or automatically upon the expiry of the pre-agreed period.
iSAFE as a financing mechanism allows startups to raise money without being at risk from having to repay a debt and without risking insolvency in case there is delay in following rounds. Moreover since it’s the share capital, the startup does not require recognition by DPIIT to use iSAFE. Unlike other SAFE structures, iSAFE allows startups who have not yet registered as startups to use it. However, the drawback of the structure is the fact that it lacks a well-established legal interpretation.
Two different kinds of protection
The honest answer to which instrument ‘better protects’ Indian startups is that it depends on whose protection we are talking about.
The iSAFE is a more protective structure for the company and its cash flow. It does not create a creditor relationship with the investors and neither does it impose a maturity date that could force a troubled company into default. A founder not wanting to give an investor a debt claim on the company in a downturn has good reason to prefer it.
The convertible note has the benefit of legal certainty and investor protection. It is grounded on a clear statutory backings with mandatory RBI filing trail, all of which provide both parties a clearer basis for resolving disputes on conversion mechanics, pricing or default. An investor seeking the security of being a recognised creditor, with the attendant rights that status confers if things go wrong, will reasonably prefer a note over an instrument whose enforceability has never been tested in court.
There also exists a filtering effect. The minimum ticket on convertible notes of 25,00,000 INR (Twenty Five Lakhs Indian Rupees) is high enough to exclude many small angel cheques. This pushes smaller investors towards the iSAFE route by default. Larger or more risk-averse investors and any round that involves non-resident investors writing meaningful-sized cheques, tend to gravitate towards notes precisely because of the statutory clarity. Tax exposure is not as much of a differentiator as it was earlier, with the abolition of the angel tax under Section 56(2)(viib) of the Income Tax Act 1961 for all classes of investors from the financial year 2025-26, having removed a major friction point that existed for premium priced CCPS issuances regardless of the instrument used.
Takeaway
Neither instrument is a strictly better answer for every Indian startup. A convertible note gives a founder negotiating clarity and an investor actual creditor status, for the cost of a hard repayment clock that can burden a company just when it can least afford to pay. An iSAFE protects the company’s balance sheet and keeps the capitalisation table simpler in the near term, at the cost of relying on a CCPS structure that has never been pressure-tested in the Indian courts. The right choice is guided by the startup’s own risk profile, its DPIIT status and how comfortable both sides are trading statutory certainty for balance-sheet safety, rather than which instrument happens to be fashionable in a given funding cycle.
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